Solid Financials Lift Russia's Sovereign Ratings—But How Far?

Moody's, the international rating agency, last week upgraded Russia's long-term foreign currency rating from Baa3 to Baa2 with a stable outlook, in an expected move. The decision takes the Russian sovereign two notches into investment grade. Moody's was the first major rating agency to grant Russia an investment grade status (Baa3) in October 2003. In late 2004, it followed this with switching the outlook on the rating to positive. Some observers were expecting an upgrade of several notches, and this latest move did not cause any notable reaction in the financial markets.

The rating agency attributes the upgrade to several positive developments. The oil producer's increasing export revenues have resulted in dramatically improved financial liquidity, while debt repayments—even ahead of schedule—have led to considerable and rapid strengthening of debt ratios. Furthermore, the agency commends Russia's prudent fiscal policies and stable politics.

Moody's recognizes that Russian fiscal policy is currently loosening. Nevertheless, it states that taking into account the (unlikely) possibility of a sudden drop in world commodity prices, Russia should have no difficulties in servicing its debt in a timely manner over the next few years. Although current-account and budget surpluses are projected to moderate in the near term, Russia's foreign currency reserves and its Stabilization Fund should continue to grow substantially, allowing for unproblematic debt-servicing capacity. Moreover, Moody's maintains that even a modest budget deficit could be easily financed in the local markets.

On a more reserved note, the rating agency lists several challenges that still face Russia, notwithstanding the many positive developments supporting the sovereign's debt-servicing ability. Notably, Moody's calls for increased competition throughout the economy and greater fiscal federalism to aid consolidation of public finances. In addition, the state should improve its regulation and service provision capacity, strengthen the judicial system, and tackle corruption. Furthermore, Russia should further develop the local capital markets and introduce better instruments for sterilizing the large capital inflows, as well as strengthen the monitoring of rapidly growing quasi-sovereign foreign currency borrowing. Finally, the agency cautions that given the very centralized political system, public spending hikes should be kept under control, especially since memories of the 1998 financial and currency crisis remain fresh.

Russia's sovereign ratings have now improved steadily since 2000, along with its solid progress on an economic recovery path following the 1998 crisis. Fitch followed Moody's in lifting Russia into investment grade in November 2004, and Standard & Poor's (S&P) joined the ranks early this year. This latest move takes Moody's level up to Fitch's, which had made its own upward move in August; S&P lifted Russia to its lowest investment grade step last January.

Russian financial fundamentals and credit ratios have indeed improved at an impressive pace over the last few years, in the wake of strong oil revenue inflows. Moreover, Russia has indicated its willingness to continue servicing its debt early. The prospect of oil prices falling considerably any time soon remains very slim. Thus, Russia's economic fundamentals and financials are likely to improve further, showing up as an ever-increasing level of foreign reserves and strong inflows into the Stabilization Fund. Thus, Russian liquidity and financial solvency are certainly under no current threat.

In terms of sovereign credit rating status, several of Russia's peers are displaying weaker debt ratios and heavier debt burdens, suggesting that Russian ratings may be on the way to further improvement. Yet again, the country still faces important hurdles on its way to even better sovereign credit standing.

As the International Monetary Fund has recently stated, Russian structural reforms, except in the banking sector, have stalled of late. The additional problem of "Dutch disease" is clear: as growth is driven by oil and the competitiveness of other sectors weakens, attempts to diversify the economy remain insufficient. The state is tightening its hold on the energy sector just as the problem of underinvestment becomes evident elsewhere. Consequently, the domestic market cannot meet the increasing domestic demand, and Russian consumers are turning to imports. While financing this is certainly no problem at present, and will not be any time soon, it does highlight a potential source of external vulnerability and the need to diversify the production structure.

Russia remains very vulnerable to external factors, and is in urgent need of diversification. The recent progress with banking reform, though, somewhat increases overall optimism. However, implementation of these reforms remains a challenge. Notably, as highlighted by a recent S&P study, the ownership structure of banks generally remains opaque. This problem was a key reason for the unrest in the Russian banking sector during the summer of 2004. Also, the efficiency and transparency of public administration remains unsatisfactory, and the investment climate remains poor. Consequently, the sovereign rating remains constrained by the extent of political, legal, and regulatory risks, as well as overshadowed by lack of progress in structural economic reforms.

Given intensifying inflationary pressures, the recent loosening of fiscal policy is worrying. Meanwhile, continuing responsible use of the Stabilization Fund for debt repayments, even if planned, cannot be counted on in the longer term, given the disagreement over economic policies within the Russian cabinet. As highlighted by the recent government debate regarding a VAT revision, the risk remains that the Stabilization Fund will be tapped for financing still further hikes in public spending. Already undermined by corruption, consistent implementation of policies and progress with needed reforms remain far from certain. In addition, the prospect of increased competition and greater efficiency in resource allocation is undermined by Russia's current move towards greater economic centralization.

While the Russian government is paying off its debts early, the corporate sector is borrowing from abroad. Notably, state-run firms need financing for carrying out mergers and investments. Indeed, sovereign upgrades may support further corporate indebtedness, by reducing borrowing costs. This prospect also highlights sources of potential financial vulnerability, should oil prices fall. The high level of oil prices and the resultant swelling of state coffers only increase the risk of dwindling support for responsible fiscal policy and early debt repayments. Clearly, tighter rules over the use of the Stabilization Fund and for regulating the borrowing of publicly run companies are needed to ensure macroeconomic stability, support the sustainability of public finances, and enhance prospects for needed economic restructuring, as well as stimulating further, solid improvement in credit ratings.